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A better Way To Gauge Earnings?

By Ali Jaffery

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May 2002 - In the last 2 years the US stock market has fallen 27%, it has not been fun!  But what’s most worrisome about this bear market is the suspicion that the earnings that the investors have long relied on to make investment decisions are widely inflated.

Fueling this debate are sharply different numbers being counted as corporate earnings.  Last year according to generally accepted accounting principles (GAAP) the companies in S&P 500 earned a net income of $28 per share.  But Wall Street came up with $45 in “pro forma” earnings.

Over the past few years, companies have developed individual criteria for the "pro forma" or "core" earnings that they report in addition to net income (which is based on GAAP). The pro forma earnings typically exclude a range of normal business expenses.

The problem is that there is no consistency in how the companies or the analyst actually calculate operating earnings.

In a bid to come up with some rules to unify earnings, and to find a better measure for operating earnings, Standard & Poor's has introduced a new definition of so-called operating earnings. This has generated a mixed reaction from Wall Street and corporate America.

For example, S&P's methodology excludes pension gains from core earnings. General Electric Co., the largest company in the S&P 500 index, posted net income of $1.41 a share in 2001, excluding an accounting change, but that figure would have shrunk to $1.11 a share under the new standards, according to S&P.

Even more controversially, S&P includes employee stock-option costs in its core earnings. That proposed change would hurt some technology companies disproportionately. For example, Cisco Systems Inc. reported a bottom-line loss of 14 cents a share in fiscal 2001. But that would become a loss of 35 cents a share under S&P's approach, largely because of the new treatment of options.

Obviously neither one of the companies is happy with S&P’s redefinition of their earnings.

S&P uses operating earnings data to calculate some of the most widely watched stock-market ratios, including the price-to-earnings ratio of the S&P 500. By establishing standards for how such earnings are calculated, it is seeking to address some investors' craving for uniform benchmarks for financial performance.

S&P’s definition of “operating income” will have an impact because the application of S&P's recommended guidelines makes operating income a smaller number -- and therefore makes the market look more expensive. Given that S&P itself will use its new standards, the market will have no choice but to follow them to some extent.
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